Current Economic and Market Environment
Economic developments over the last month have included sticky inflation, the fear of a wage-price spiral and a return of central banks hiking interest rates. These all weighed on public and private markets at the end of the second quarter. The RBA surprised the market with an increase in the cash rate in June; this was influenced by the Fair Work Commission’s Annual Wage Review decision with the increase of minimum wage rates in modern awards by 5.75% effective 1st July 2023. RBA Governor Philip Lowe did give an insight into his views in late May when speaking to a Senate committee that “if there is no productivity growth then it’s hard to have growth in real wages”. Hence the connection between the wage review decision and the RBA’s move. This opens the door to further hikes and additional pressures on households and businesses.
The impact on the economy is likely to be a deeper downturn and higher probability of a recession. Australian shares have underperformed US and most global share markets in the June quarter so far. 10-year bond yields rose higher, factoring in higher peak interest rates. This is quite a turnaround from two months ago when most investors assessed that the RBA had finished rate hikes. House prices rebounded for two months from their earlier lows, however the additional rate hikes could see a second wave of house prices dropping again
Our outlook for the remainder of 2023 is that we see a material risk of deep economic downturn or recession with a reconnection of asset markets to this emerging reality. A bullish case is that inflation fades faster and further rate hikes are unnecessary, while a more bearish case may involve further systemic issues and an even deeper recession.
Private Market long term trends
By comparison, most private markets have been relatively stable as they are not impacted by daily market fluctuations. Repricing is slower and volatility lower, with capital still flowing into private markets despite some investors holding back. While we have seen no material public market IPOs, there has been some merger and acquisition activity within private markets as lofty pricing expectations have been reset lower, and some companies are beneficiaries of finding compelling acquisition opportunities.
Longer-term trends are more compelling for private markets. We have previously highlighted the trends towards companies remaining private longer, disintermediation of bank lending, and more innovation and growth. The acceleration of trends of AI and digital augmentation of business means that there are fewer barriers to companies starting up, staying private and growing. Public markets unfortunately are contracting. Long term cycles every ten years or so see periods of pause in allocations, and this sees better pricing and vintage year performance. We believe we are in one of these ten-year opportunity cycles now.
The most compelling reasons to have private markets in place for the long term continue to be better returns, lower volatility, a broader range of opportunities, as well as access to the middle market business economy where most of the growth, innovation and employment is taking place. We also believe in consistently surveying the landscape to find the best performing funds, as these tend to have persistently good performance and are difficult to access. The negatives of private markets have been limited liquidity but even this is being addressed with product innovation and private market trade matching platforms.
Approaches to private markets
Investor approaches to these asset classes can start with less risky fund of funds and core strategies, and then seek best-of-breed individual fund and more core plus and opportunistic strategies. Diversification is key in managing risk and we would advocate a fund or fund of funds approach. We support a single investment in property funds where there is a tangible asset backing the investment. For single private debt investments, we prefer tangible property assets, however we are more cautious about single loans in companies or riskier property development assets. Similarly for single company capital raisings, we prefer these are undertaken via co-investment funds and not taken as a single investment because the due diligence requirements and adverse selection of offers for an individual investor. The track record of the fund manager and individuals is a key selection criteria for our private market offerings. This approach remains a solid foundation from which to address shorter term variations and opportunities.
Some sectors have had some pricing adjustments and there has been a convergence of buyer and seller expectations. While we have seen some increases in capitalization rates and downward adjustment in prices this has been very selective by sector and within sectors. Office space remains out of favour and we have seen some sales by larger landlords to rebalance out of less favoured assets. Retail is very out of favour but has attracted some more value-oriented specialist retail fund managers buying selectively. Industrial continues to be well supported due to low vacancy rates, constrained new supply and strong rental growth. Niche sectors such as healthcare and childcare, hospitality and self-storage retain fundamental demand strength. Some pause and adjustment in valuations across sectors has been observed as debt funding costs and yields on property have risen. The adjustment has depended on the balance of supply and demand adjusted for funding. Hence there is opportunity selectively across most sectors with a preference for value add and opportunistic, while core and core plus property can be attractive if bought cheaply vs older valuations.
Venture Capital and Private Equity
We are seeing a continued adjustment across private equity and venture capital portfolios. There have been companies fortunate to have raised capital earlier and now have plenty of runway to grow, while those that are trying to raise capital now from their private equity or venture capital sponsors are facing a more difficult task. This divergence creates opportunities. With capital discipline imposed we will see better quality companies rise to the top with less competition than before. Those that need to raise capital and get funded will be, by definition, also the stronger companies. Exit opportunities through IPOs are limited in a softening economic environment while M&A activity is very selective with corporate and private equity acquirers being more cautious. Hence, we believe the 2022 and 2023 vintage years will be very attractive. To access these opportunities, there are mostly long lockups required. However, we have also seen some semi-liquid funds with moderate liquidity as often as quarterly or monthly. There are limits though, with several funds restricting redemptions, and no more than 5% outflow of a fund per quarter quite commonly seen. Secondary market opportunities are attractive however we note selection is very important given that there have been quite a few secondaries funds raising capital. Therefore, the selection of the right areas and disciplined secondary fund managers is essential.
While we see a long-term supportive trend towards more private debt funding as local and global banking regulations lead to more fund raising in private markets, there are some shorter-term warning signs. The more challenged environment for most forms of private debt include adjustments to valuations in real estate, a more challenged corporate environment, stretched consumer lending, and some structured and specialty finance lending pressures. However, it is a very attractive time to be in opportunistic and special situations credit for the right fund operators. From a financial system point of view we have noted more analysis by financial regulators and central banks given the less regulated and systemic impact of non-bank lenders. We have identified a plethora of private debt funds raised for property lending in various forms. Some of these may have funding constraints as delays, arrears and defaults emerge. Again, we see deeper analysis and selecting quality fund manager partners as key. Opportunities in niches we have identified include some very well diversified and quality credit opportunities. Examples are the management rights debt fund from last year, and a parallel lending fund to European corporate borrowers we will launch shortly.
We see agriculture as a long-term natural asset diversifier with superior long term returns. Being able to select in a middle market niche between very large institutional allocators and smaller family owners is where we see the most opportunity. Selecting the best farm operators within each market and buying existing known assets rather than a blind pool is preferable. Market structure and commodity risk is also assessed alongside the degree to which key inputs can be controlled. Successful agriculture is a combination of best practices applied to the inputs of land, water, climate, topography, farm technology and human expertise. Some strategies can disaggregate some of these such as water only strategies, land only sale and leaseback, and agricultural technology. Others will combine these with best practice corporatized management at growing scale. Our research and engagement with agricultural operators has narrowed down some preferred choices. The strength of agriculture in portfolios is the natural growth and natural diversification that hedges portfolios from inflation risk while also providing some social and environmental benefits.
The infrastructure landscape has evolved over the past few years culminating in more new infrastructure applied to themes such as energy transition and environmental management. We also see an evolution in some of the traditional infrastructure assets. We were pleased to be able to identify a unique opportunity to acquire one of the best single infrastructure assets in Australia with our recent Wholesale Airports Access Fund with a holding in Melbourne and Launceston Airports. This is historically one of the best performing assets in Australian infrastructure and with much the same mix of drivers of future returns, the opportunity is attractive. We will continue to look for the highest quality single asset and multi-asset infrastructure fund opportunities. Complementing this we also see single fund middle market and value add infrastructure appealing, with some fund of fund options worthy of consideration. We think there is an attractive niche for wholesale investors to get access to institutional quality and larger ticket size investments through feeder and access funds. While rising interest rates may be a concern for some infrastructure investments, those that are able to pass on inflation are at an advantage and can be an effective inflation hedge.
While we see a wide range of other alternatives in public and private markets, we do focus more on what may be available in niche and specialty markets in private markets with the same principles we apply to all asset classes. These principles are to select the best and longest heritage teams, in middle markets, with strong operational skills and value add from development. Larger size can be an advantage but very selectively where size is used for investors advantage, i.e. to create value with tools that fewer others can apply. Very small and early-stage teams are less likely to gain attention unless there is a solid track record of a team from another firm and we see an edge in being able to select them ourselves or with fund manager partners. Opportunistic strategies are attractive to apply capital with skill to areas where capital becomes scarce.
Finally, we seek to match a range of investor needs across our client and partner network to aggregate interest and create opportunities on behalf of you all. It is our mission to address the problem that individual investors deserve better by creating solutions for better portfolios and lifestyle outcomes.